The real reason why oil prices are rising

By now it is becoming too obvious that the United States is playing the oil game all over again. And this is the desperate gamble of a country whose economy is neck deep in trouble.

Given this scenario, managing prices of oil is central to the US economic architecture. Expectedly, this gamble has been played in a great alliance between the US government, US financial sector and the media.

I have earlier written about:

• The impending collapse of the US dollar on account of the inherent weakness in the US economy caused by its structural weakness as reflected in the sub-prime crisis;
• The repeated softening of the interest rates in the US that has the potency to kill the US dollar; and
• How the fall in the US dollar suits the US corporate sector, especially its omnipotent financial sector.

Naturally, since the past few years, the US financial sector has begun to turn its attention from currency and stock markets to commodity markets. According to The Economist, about $260 billion has been invested into the commodity market -- up nearly 20 times from what it was in 2003.

Coinciding with a weak dollar and this speculative interest of the US financial sector, prices of commodities have soared globally.

And most of these investments are bets placed by hedge and pension funds, always on the lookout for risky but high-yielding investments. What is indeed interesting to note here is that unlike margin requirements for stocks which are as high as 50 per cent in many markets, the margin requirements for commodities is a mere 5-7 per cent.

This implies that with an outlay of a mere $260 billion these speculators would be able to take positions of approximately $5 trillion -- yes, $5 trillion! -- in the futures markets. It is estimated that half of these are bets placed on oil.

• Oil price hike: Govt can't save you: PM

Readers may note that oil is internationally traded in New York and London and denominated in US dollar only. Naturally, it has been opined by experts that since the advent of oil futures, oil prices are no longer controlled by OPEC (Organization of Petroleum Exporting Countries). Rather, it is now done by Wall Street.

This tectonic shift in the determination of international oil prices from the hands of producers to the hands of speculators is crucial to understanding the oil price rise.

Today's oil prices are believed to be determined by the four Anglo-American financial companies-turned-oil traders, viz., Goldman Sachs, Citigroup, J P Morgan Chase, and Morgan Stanley. It is only they who have any idea about who is entering into oil futures or derivative contracts. It is also they who are placing bets on oil prices and in the process ensuring that the prices of oil futures go up by the day.

But how does the increase in the price of this oil in the futures market determine the prices of oil in the spot markets? Crucially, does speculation in oil influence and determine the prices of oil in the spot markets?

Answering these questions as to whether speculation has supercharged the demand for oil The Economist, in its recent issue, states: 'But that is plain wrong. Such speculators do not own real oil. Every barrel they buy in the futures markets they sell back again before the contract ends. That may raise the price of 'paper barrels,' but not of the black stuff refiners turn into petrol. It is true that high futures prices could lead someone to hoard oil today in the hope of a higher price tomorrow. But inventories are not especially full just now and there are few signs of hoarding.'

On both counts -- that speculation in oil is not pushing up oil prices, as well as on the issue of the build-up of inventories -- the venerable Economist is wrong.

The finding of US Senate Committee in 2006

In June 2006, when the oil price in the futures markets was about $60 a barrel, a Senate Committee in the US probed the role of market speculation in oil and gas prices. The report points out that large purchase of crude oil futures contracts by speculators has, in effect, created additional demand for oil and in the process driven up the future prices of oil.

The report further stated that it was 'difficult to quantify the effect of speculation on prices,' but concluded that 'there is substantial evidence that the large amount of speculation in the current market has significantly increased prices.'

The report further estimated that speculative purchases of oil futures had added as much as $20-25 per barrel to the then prevailing price of $60 per barrel. In today's prices of approximately $130 per barrel, this means that approximately $100 per barrel could be attributed to speculation!

But the report found a serious loophole in the US regulation of oil derivatives trading, which according to experts could allow even a 'herd of elephants to walk to through it.' The report pointed out that US energy futures were traded on regulated exchanges within the US and subjected to extensive oversight by the Commodities Future Trading Commission (CFTC) -- the US regulator for commodity futures market.

In recent years, the report however pointed out to the tremendous growth in the trading of contracts which were traded on unregulated OTC (over-the-counter) electronic markets. Interestingly, the report pointed out that the trading of energy commodities by large firms on OTC electronic exchanges was exempted from CFTC oversight by a provision inserted at the behest of Enron into the Commodity Futures Modernization Act in 2000.

The report concludes that consequential impact on account of lack of market oversight has been 'substantial.'

NYMEX (New York Mercantile Exchange) traders are required to keep records of all trades and report large trades to the CFTC enabling it to gauge the extent of speculation in the markets and to detect, prevent, and prosecute price manipulation. In contrast, however, traders on unregulated OTC electronic exchanges are not required to keep records or file any information with the CFTC as these trades are exempt from its oversight.

Consequently, as there is no monitoring of such trading by the oversight body, the committee believes that it allows speculators to indulge in price manipulation.

Finally, the report concludes that to a certain extent, whether or not any level of speculation is 'excessive' lies entirely in the eye of the beholder. In the absence of data, however, it is impossible to begin the analysis or engage in an informed debate over whether our energy markets are functioning properly or are in the midst of a speculative bubble.

That was two years back. And much water has flown in the Mississippi since then.

The link to the spot markets

Now to answer the second leg of the question: how speculators are able to translate the future prices into spot prices.

The answer to this question is fairly simple. After all, oil price is highly inelastic -- i.e. even a substantial increase in price does not alter the consumption pattern. No wonder, a mere 3-4 per cent annual global growth has translated into more than a 40 per cent annual increase in prices for the past three or four years.

But there is more to it. One may note that the world supply and demand is evenly matched at about 85 million barrels every day. Only if supplies exceed demand by a substantial margin can any downward pressure on oil prices be created. In contrast, if someone with deep pockets picks up even a small quantity of oil, it dramatically alters the delicate global demand-supply gap, creating enormous upward pressure on prices.

What is interesting to note is that the US strategic oil reserves were at approximately 350 million barrels for a decade till 2006. However, for the past year and a half these reserves have doubled to more than 700 million barrels. Naturally, this build-up of strategic oil reserves by the US (of 350 million barrels) is adding enormous pressure on the oil demand and consequently its prices.

Do the oil speculators know of this reserves build-up by the US and are indulging in rampant speculation? Are they acting in tandem with the US government? Worse still, are they bordering on recklessness knowing fully well that if the oil prices fall the US government will be forced to a 'Bears Stearns' on them and bail them out? One is not sure.

But who foots bill at such high prices? At an average price of even $100 per barrel, the entire cost for the purchase of this additional 350 million barrels by the US works out to a mere $35 billion. Needless to emphasise, this can be funded by the US by allowing it currency printing presses to work overtime. After all, it has a currency that is acceptable globally and people worldwide are willing to exchange it for precious oil.

No wonder Goldman Sachs predicts that oil will touch $200 to a barrel shortly, knowing fully well that the US government will back its prediction.

And, in the past three years alone the world has paid an estimated additional $3 trillion for its oil purchases. Oil speculators (and not oil producers) are the biggest beneficiaries of this price increase.

In the process, the US has been able to keep the value of the US dollar afloat -- perhaps at an extra cost of a mere $35 billion to its exchequer!

The global crude oil price rise is complex, sinister and beyond innocent economic theories of demand and supply. It is speculation, geopolitics and much more. Obviously, there is a symbiotic link between the US, the US dollar and the oil prices. And unless this truth is understood and the link broken, oil prices cannot be controlled.

Other articles by the author:

• Is the US economy heading for a collapse?
• Derivatives: The time bomb in our financial system
• Pay panel, an attempt to destabilise India
• Anything multiplied by zero is zero indeed!